Risk Rating System for DOVs

Introduction

With the recent discussion on the origins and risks of DeFi Option Vault (DOV) yield, the Thetanuts Team sought to improve the understanding of the risks of our products.

There are many different methodologies to evaluate the risks of selling options. We have created a simple rating to approximate the risks. Its simplicity of it ensures that it is easily replicable for any retail user.

With the risk rating in place, we hope to enable users to make better-informed decisions by understanding the approximate risk parameters they are exposed to in various vaults.

Risk Rating Methodology

Fundamentally, a DOV seeks to provide accessibility to earn yield through structured products (SP) that would not otherwise be possible as retail users, especially on altcoins.

Yield generation from SPs most often start from selling vanilla products such as covered calls and cash secured puts. In our view, the risk of selling SPs primarily stems from volatility. As a seller, you have positioned yourself to express the view that implied volatility is mispriced and that realized volatility will be lower than implied vol through the tenor of the option. Therefore harvesting the variance risk premium between implied and realized volatility. It can be said that there is a directional component too! However, at the root of it, it is all about volatility. Should volatility spike, you will likely incur losses.

Therefore, to then understand the risk of selling, we need a measure of how risky the act of selling is at any given point of time.

To achieve this, we look at 3 key ideas about volatility:

1. Volatility is a mean reverting process
2. We should not long or short volatility based on absolute values alone. We need to consider the volatility of volatility, to contextualize the current volatility regime
3. Volatility tends to cluster, be it low volatility or high volatility regimes

When both “Vol of vol” and “vol” are low, volatility is likely to expand in the future and revert back to the mean. On the other hand, when volatility is heightened, it isn’t always the best idea to sell vol, as it tends to cluster and continue to echo for a period. From this, we can derive a risk metric.

As for the directional component of the option (call or put), we rely on a simple moving average to give a sense of trend and attach the risk to it.

Procedure

1. Compute the absolute Zscore of SMA30 of annualized realized volatility (Zscore gives us the “Vol of vol”)
2. We define a high risk condition when the Zscore is either < 0.5 or > 2
3. To determine if a call or put carries more risk, we consider the current market trend through SMA100

The following table below summarizes the results from the procedure above:

Results

The following charts are a visual representation of the risk rating methodology that we have devised. When the background color is red, it represents high risk for puts, and green represents high risk for calls. While it is not perfect (as nothing ever is), it gives a good heuristic to work off from.

An example of BTC

Summary

It is important to note that our risk metrics are not meant as an absolute measure or provide any form of financial advice. For example, low risk does not mean that users may not be exposed to no risk or highly negative tail events.

Instead, we believe that this will enable users to make better decisions when deciding which vaults to leverage for yield generation activities, having the advantage of being fully aware of the risk profiles they are taking on.

In the next medium post, we will be discussing a new implementation of APY, a new metric that Thetanuts Finance would like to propose to the DOV space that allows users to best evaluate the risk profile that they are taking on.